Disregarded, Consolidated And Surly

 

I was reading a consolidated group tax case recently.

It made me think: it has been a moment since I have worked with a consolidated return. It did however remind me a of a favorite tax term.

I consider consolidated groups more the realm of Fortune 500 companies. The reason is that these companies have publicly-traded stock, and publicly-traded stock is a cousin (if not a sibling) to cash. If I am a Fortune 500 and want to buy your company, I am motivated to use my stock to pay for some/all of the purchase price. Why? Because I am not depleting my cash reserves. Since my stock is publicly-traded, however, you are likely to consider it as similar to cash, but being stock there may be tax strategies available to avoid the heavy hand of immediate taxation. It is about as close to a win:win as you can find in the Code.

Let’s take a brief look at this part of the Code.

What is a Consolidated Tax Return?

First of all, we are now talking about corporations. These corporations have sufficient common ownership (that is, are “affiliated”) to combine their separate tax returns into one (“consolidated”) tax return which will be treated as a single unit for tax purposes.

        Code § 1501 - Privilege to file consolidated returns

An affiliated group of corporations shall, subject to the provisions of this chapter, have the privilege of making a consolidated return with respect to the income tax imposed by chapter 1 for the taxable year in lieu of separate returns. The making of a consolidated return shall be upon the condition that all corporations which at any time during the taxable year have been members of the affiliated group consent to all the consolidated return regulations prescribed under section 1502 prior to the last day prescribed by law for the filing of such return. The making of a consolidated return shall be considered as such consent. In the case of a corporation which is a member of the affiliated group for a fractional part of the year, the consolidated return shall include the income of such corporation for such part of the year as it is a member of the affiliated group.

As shorthand, we will refer to the area of the tax Code that deals with consolidated returns as the “15XX Regulations.”

Who Can File a Consolidated Return?

The affiliated group will have at least two corporations connected through a common parent. The corporations (other than the parent) must be at least 80% owned by another corporation (it does not have to be the parent) in the group.

In general, S corporations and foreign corporations cannot be members of an affiliated group. 

BTW you can remain an affiliated group indefinitely and not elect to file a consolidated return.

Like Hotel California, however, once you elect it is not so easy to leave.

Why Would I File a Consolidated Return?

One key advantage is being able to offset the losses from one member of the group against the income of another member.

If one were to file separately, then the profitable member would have taxable income (and pay tax) while the loss member would have a net operating loss that carries over to some future profitable year. It is not the end of the world, but one would probably prefer to use those NOLs now.

How Do Affiliated Corporations Come into Existence?

The first way is organic: the parent creates a subsidiary. In a later year, perhaps the parent creates another subsidiary, or an existing subsidiary creates a new subsidiary.

A second way is to acquire other corporations via mergers and acquisitions.

As shorthand, we will refer to the area of the tax Code that deals with corporate formations, mergers, acquisitions and divisions as the “3XX Regulations.”

Are the Rules Complicated?

You bet.

The 15XX Regulations are some of the most difficult and byzantine rules you will ever work through.

And the 15XX Regulations - just to make it sporting - like to cross-reference the 3XX Regulations.

You will spend time flipping pages, at least until you memorize the citations.

Let’s Look at One Rule: The SRLY

This is pronounced “surly.”

The idea is that a corporation enters the consolidated group with net operating losses. One’s first thought is that the group can immediately use those losses to offset income from other members.

No, it can’t. Congress thought of this, which is how SRLY came into existence.

In general, the SRLY rules will limit the use of net operating losses to future income from the same corporation that brought the losses into the group.

There is a cousin to this rule in 3XX Regulations upon ownership changes, but it does not require an affiliated group. SRLY, on the other hand, is found in the 15XX Regulations and applies to consolidated groups.

Let’s Look at a Recent Case Involving a SRLY

As we have sometimes done before, we will change the names to make this more readable.

Scooby was created pursuant to a reorganization in 2012. Scooby was an S corporation, and it had a subsidiary called Shaggy, itself another S corporation. An S corporation generally cannot have a corporation as a shareholder, so Scooby elected to treat Shaggy as a Qualified Subchapter S Subsidiary (QSSS).

Shaggy in turn acquired a C corporation we will call Daphne. A C corporation (as contrasted to an S corporation) can have a corporation as a shareholder. Daphne was dragging net operating losses behind it.

Shaggy distributed Daphne to Scooby.

At this point we have an S corporation (Scooby) owning a C corporation (Daphne) and an S corporation subsidiary (Shaggy).

COMMENT: We are not there yet, but you see a key piece to a potential SRLY: a C corporation with NOL carryovers. To provoke SRLY, we next need a consolidated group.

In 2018 Scooby revoked its S election.

Scooby elected to treat Daphne as a disregarded entity. For federal tax purposes, Daphne liquidated into Scooby and ceased to exist as a separate entity.

Scooby then formed a consolidated group (which we will call Super Scooby).

Super Scooby was knocking it out of the park. It had group taxable income of $13 million for 2018, $46 million for 2020, and $89 million for 2021, even though Scooby/Daphne had zero (-0-) profit of its own. All the profit was coming from the subsidiaries.

Super Scooby – of course – wanted to use the corporation-previously-known-as-Daphne NOLs. The amount was significant - $108 million.

The IRS said No. Why? Because of SRLY, that’s why.

Off to Tax Court they went.

Super Scooby had a straightforward argument: there was no SRLY because Daphne was disregarded. What was Daphne’s was now Scooby’s, and there is no SRLY rule on the parent of an affiliated group.

True, but there is a “predecessor and successor” rule in the thicket of the 15XX Regulations.

The IRS saw Daphne as a predecessor. Super Scooby did not. Super Scooby argued that Scooby once owned Daphne as a separate corporation. After the S revocation, Daphne ceased to exist, and there remained only Scooby.  Super Scooby was then created upon election to file a consolidated return.

Why the pedantism?

Super Scooby wanted the “lonely parent” exception found in the 15XX Regulations.

COMMENT: I love this term. The idea is that the parent can always drag its NOLs behind it without SRLY restrictions. The idea makes sense if the parent remains the same. It makes less sense if the tax planners restructure the group to result in a new parent, or – as in this case – when a previously existing corporation goes “poof” into the parent.

Do you test the lonely parent before or after the poof?

Super Scooby argued that the test was after the poof.

The IRS of course argued that the test was before.

The Court approached the issue by looking at the predecessor-successor rules in the 3XX Regulations:

In general, a predecessor is any transferor in a Section 381 transaction.”

COMMENT: Section 381 addresses carryovers when corporations acquire corporations.

                

Scooby “acquired” Daphne when it revoked its S election and Daphne liquidated under Section 332. The liquidation triggered Section 381 for any Daphne carryovers, which in turn triggered the “transferor in a Section 381 transaction” requirement for a predecessor-successor.

Daphne was a predecessor.

On to the lonely parent:

Where a member of the group is the successor in a 381 transaction, any net operating loss of the predecessor corporation are considered to have occurred in a SRLY if the predecessor was not a member of the group for each day of such year. The lonely parent rule does not apply in these situations, and the loss carryovers are subject to the SRLY restrictions, despite the fact that the common parent may be the successor corporation in the 381 transaction.”

In recap, the Court reasoned that:

• Daphne was a predecessor.

• Daphne was never a member of the Super Scooby consolidated group.

• The lonely parent rule cannot be extended to predecessors not members of the (consolidated) group.

• Daphne’s SRLYs remained SRLYs.

Super Scooby struck out trying to claim Daphne’s NOLs.

Why was Super Scooby swinging so hard? There was consolidated taxable income of – what? - $13 million, $46 million, $89 million. There appeared plenty of income to go around.

But there wasn’t.

All the consolidated income came from the subsidiaries.

The Daphne SRLY looked only at the income that Daphne (now liquidated into Scooby) brought into the consolidated group.

Scooby/Daphne itself had zero (-0-) income.

Meaning the SRLY was also limited to zero (-0-).

NOTE: The solution to Super Scooby’s problem seems straightforward: why not check-the-box to disregard one (or more) subsidiaries as separate from Scooby? Scooby would then have income to absorb the Scooby/Daphne NOLs. Yes, we still have a SRLY, but we are putting (as much) income (as necessary) into Scooby/Daphne to release some/all of the NOL. Maybe we burn the NOL over several years rather than just one, but that is still a better result than the above.

Our case this time was HBM Holdings Co v Commissioner, 167 T.C. No. 6 (July 27, 2026).

Divorced Parents And A Dependent Child

 It is one of my least favorite issues in tax practice.

Who is entitled to a dependent?

Granted, there is no longer a dependency exemption available, but there are other tax items, such as the child tax credit, that require a dependent.

The issue can go off-the-rails if the parents are (a) divorced and (b) combative.

It occurs when both parents claim the same child for the same year.

One of the parents is going to lose the dependency, of course, but how the Code determines which one may surprise you.

The Code wants to know which is the custodial parent – that is, which parent did the child live with for the majority of the year. Granted, in some cases the answer may be razor close, but most of the time there is a clear answer.

The Code anticipates that the custodial parent will claim the child.

What if the noncustodial parent provides most of the child’s support?

The Code (for the most part) does not care.

How does the noncustodial parent get to claim the child?

If the parents get along, then there is no issue. Everyone follows the rules and there is no tax controversy.

If the parents do not get along and both claim the same child, the IRS is going to get involved. It will want to know: who is the custodial parent?

But the divorce decree says ….

You might be surprised how little the IRS cares about that divorce decree.

What it is interested in is whether a certain form was filed with the noncustodial parent’s return: Form 8332.

This form has to be signed by the custodial parent. If the parents do not get along, you can see the problem.

What happens if the noncustodial parent does not attach this form and both parents claim the child?

Let’s take a look at the DeMar case.

The divorce decree said that Mr Demar (Dad) was to claim the son in odd-numbered years. Dad claimed the son for 2015.

Mrs DeMar (Mom) also claimed the son.

The IRS came in. There (of course) was no Form 8332. The IRS could care less what that divorce decree had to say, so off to Tax Court they went.

Dad is going to lose this all day every day, except ….

Would you believe that – before the Tax Court hearing – Mom signed Form 8332?  

That doesn’t happen much.

There is a proposed Regulation on this point:

A noncustodial parent may submit a copy of the written declaration to the IRS during an examination to substantiate a claim to a dependency exemption for the child.

Did that save Dad?

Let’s keep reading:

A copy of a written declaration attached to an amended return, or provided during an examination, will not meet the requirement of this paragraph … if the custodial parent … has not filed an amended return to remove that claim to a dependency exemption for the child.

So one can file the 8832 late but one also has to prove that the other parent amended his/her return to remove the dependency for the child.

Guess what?

Mom did not amend her return.

Dad lost.

The IRS did not care about that divorce decree and the odd-numbered year.

I get it. The IRS has no intention of playing family court, so it established mechanical rules for the dependency. The average person focuses on the divorce decree – understandably – but the IRS does not.  Procedure is everything in this area.

Our case this time was DeMar v Commissioner T.C. Memo 2019-91.

Change In The Kiddie Tax

Congress took a tax calculation that was already a headache and made it worse.

I am looking at a tax change included in the year-end budget resolution.

Let’s talk again about the kiddie tax.

Years ago a relatively routine tax technique was to transfer income-producing assets to children and young adults. The technique was used mainly by high-income types (of course, as it requires income), and the idea was to redirect income that would be taxed at a parent’s or grandparent’s (presumably maximum) tax rate and tax it instead at a child/young adult’s lower tax rate.

As a parent, I immediately see issues with this technique. What if one of my kids is responsible and another is not? What if I am not willing to just transfer assets to my kids – or anyone for that matter? What if I do not wish to maximally privilege my kids before they even reach maturity? Nonetheless, the technique was there.

Congress of course saw the latent destruction of the republic.

Enter the kiddie tax in 1986.

In a classroom setting, the idea was to slice a kid’s income into three layers:

(1)  The first $1,050

(2)  The second $1,050

(3)  The rest of the kid’s income

Having sliced the income, one next calculated the tax on the slices:

(1)  The first $1,050 was tax-free.

(2)  The second $1,050 was taxed at the kid’s own tax rate.

(3)  The rest was taxed at the parents’ tax rate.

Let’s use an example:

(1)  In 2017 the kid has $20,100 of income.

(2)  The parents are at a marginal 25% tax rate.

Here goes:

(1)  Tax on the first slice is zero (-0-).

(2)  Let’s say the tax on the second slice is $105 ($1,050 times 10%).

(3)  Tax on the third slice is $4,500 (($20,100 – 2,100) times 25%).

The kid’s total 2017 tax is $4,605.

Let’s take the same numbers but change the tax year to 2018.

The tax is now $5,152.

Almost 12% more.

What happened?

Congress changed the tax rate for slice (3). It used to be the parent’s tax rate, but starting in 2018 one is to use trust tax rates instead.

If you have never seen trust rates before, here you go:

          

Have over $12,500 of taxable income and pay the maximum tax rate. I get the reasoning (presumably anyone using trusts is already at a maximum tax rate), but I still consider these rates to be extortion. Sometimes trusts are just that: one is providing security, navigating government programs or just protecting someone from their darker spirits. There is no mention of maximum tax rates in that sentence.

Let’s add gas to the fire.

The kiddie tax is paid on unearned income. The easiest type to understand is dividends and interest.

You know what else Congress considered to be unearned income?

Government benefits paid children whose parent was killed in military service. These are the “Gold Star” families you may have read about.

Guess what else?

Room and board provided college students on scholarship.

Seriously? We are taking people unlikely to be racking Thurston Howell III-level bucks and subjecting them to maximum tax rates?

Fortunately, Congress – in one of its few accomplishments for 2019 – repealed this change to the kiddie tax.

We are back to the previous law. While a pain, it was less a pain than what we got for 2018.

One more thing.

Kids who got affected by the kiddie tax changes can go back and amend their 2018 return.

I intend to review kiddie-tax returns here at Galactic Command to determine whether amending is worthwhile.

It’s a bit late for those affected, but it is something.

Your Child Wins A Beauty Pageant

We are in a mini “tax season” here at Galactic Command, with September 15 being the deadline for business returns. Next month is the extended due date for the individual returns.

I wanted to find something light-hearted to discuss. Call it a salve to my sanity.

Let’s talk about your kid. Yes, the one who will soon be discovered on America’s Got Talent. It could happen. He could be the next Jonathan, or she the next Charlotte.

COMMENT: Jonathan and Charlotte were discovered on Britain’s Got Talent. It is worth watching their first appearance, if only for Simon’s reaction.

Say your kid wins prize money.

This being a tax blog: who pays tax on the money – the kid or you? After all, the kid is your dependent. He/she is nowhere near emancipated.

Here is a Code section one could spend a career in practice and not see:

 § 73 Services of child.

(a)  Treatment of amounts received.

Amounts received in respect of the services of a child shall be included in his gross income and not in the gross income of the parent, even though such amounts are not received by the child.

(b)  Treatment of expenditures.

All expenditures by the parent or the child attributable to amounts which are includible in the gross income of the child (and not of the parent) solely by reason of subsection (a) shall be treated as paid or incurred by the child.

The daughter of our protagonists (Lopez) started competing in beauty pageants at age nine. There were expenses involved with this, such as travel, outfits, cosmetics and so on. In 2011 and 2012 she won a couple of dollars, approximately $3,200 to pin it down.

Which was nowhere near the expenses of over $37 grand across the two years.

They used an Enrolled Agent with over 40-years’ experience to prepare their return.

COMMENT: An E.A. is an IRS-administered exam on tax proficiency. While perhaps not as well-known as the CPA, it is a substantial credential. There are many CPAs who practice outside tax, for example, but all E.A.’s practice tax.

The E.A. decided to put the daughter’s income on the parent’s return. He arrived at that conclusion by reviewing state child labor laws. He gave it a lot of thought, but he missed Code Section 73.

As I said, it is rare that one would blow dust off that section.

He prepared the parent’s return, including the daughter’s prize money.

That part was only $3 grand or so. The sweet part was the $37 grand in expenses. The parents took a BIG tax loss.

And the IRS tagged the return.

The Lopez’s fought the IRS. There was also a second IRS adjustment, so I presume they decided that fighting one was the same effort as fighting both.

The kid’s income and expenses, however, was a clear loser.  

The IRS adjusted their income by over $30 grand, so they came in with a souped-up penalty – the “accuracy related” penalty. That bad boy parachutes in at 20%. The IRS likes to toss that one out like hot-sauce packets at Gold Star.

Remember the E.A.?

The Court pointed out that the Lopez’s hired a tax professional. He researched the issue. Granted, he arrived at the wrong answer, but that was not the Lopez’s fault. They hired a professional, and they reasonably relied upon the advice of the professional.

The Court dismissed the penalties.

Small consolation, but something.

How To Lose A Tax Deduction For Wages Paid

This weeks’ tax puzzler involves a mom and her kids.

We again are talking about attorneys. Both mom and dad are attorneys, and mom is self-employed.

Sometimes she brought her children to the office, where they helped her with the following:

·        answering the telephone

·        mail

·        greeting clients

·        photocopying

·        shredding unneeded documents

·        moving files

Mom believed that having her children work would help them understand the value of money and lay the foundations for a lifelong work ethic.

She had three kids, and for 2006, 2007 and 2008 she deducted wages of $5,500, $10,953 and $12,273, respectively.

There are tax advantages to hiring a minor child. For example, if the child is age 17 or younger, there are no social security (that is, FICA) taxes. In addition, there is no federal unemployment tax for a child under age 21, but that savings pales in comparison to the FICA savings.

Then you have other options, such as having the child fund an IRA. All IRAs require income subject to social security tax. It doesn’t matter if one is an employee (FICA tax) or is self-employed (self-employment taxes), but social security is the price of admission.

Her children were all under the age of ten. Can you imagine what those IRAs would be worth 50 years from now?

The IRS disagreed with her deducting payroll, and they wound up in Tax Court.

Your puzzler question is: why?

(1) You: The Court did not believe that the kids really did anything. Maybe she was just trying to deduct their allowances.

Me: The tax law becomes skeptical when related parties are involved, and you cannot get much more related than a mother and her children.  It was heightened in this case as the children were so young. For the most part, though, the Court believed her when she described what the children did.

(2) You: Mom used the money she “paid” the kids for their support – like paying their school tuition, for example.

Me: The tax law disallows a deduction if the money is disguised support, which tax law expects to be provided a dependent child. In this case, the Court saw the children buying books, games and normal kid items; some money also went to Section 529 plans. The Court did not believe that mom was trying to deduct support expenses.

(3) You: She could not provide paperwork to back-up her deductions. What if she paid the kids in cash, for example?

Me: Good job. One reads that the Court wanted to believe her, but she presented no records. She did not provide bank statements showing the kids depositing their paychecks, presumably because the children did not have bank accounts.

She did not provide copies of the Section 529 plans. That was so easy to do that I found the failure odd.

At least she could show the Court a Form W-2.

Mom had not even issued W-2s.

The Court was exasperated.

It allowed her a deduction of $250 per child, as it believed that the kids worked. It could not do more in the absence of any documentation.

And there is the answer to the puzzler.

Too often it is not mind-numbing tax details that trip-up a taxpayer. Sometimes there is just a lapse of common sense.

Like issuing a W-2 if you want the IRS to believe you paid wages to somebody.